The FOMC July meeting shift
Yesterday’s FOMC statement and press conference confirmed that the Fed is aiming to lower its Fed Funds target interest rate at its September meeting absent any big surprises. The Fed is shifting its focus from solely combating inflation to a more balanced approach, considering both inflation and employment.
This shift is supported by recent economic reports, including the Employment Cost Index, which increased just 0.9% in the second quarter, or at 3.7% on an annualized rate, down from last year’s peak of more than 5%. A weaker labor market, combined with inflation running at approximately 2.5% according to the Fed’s favored PCE inflation index, should provide the confidence the FOMC has been seeking before lowering rates. It now seems the Fed is increasingly fearful of rising unemployment and less concerned about a resurgence in inflation.
The Fed may be underestimating the potential downturn in the job market, particularly for small businesses. The July ADP report showed that payrolls declined by 22,000 jobs for small companies with between 20-49 workers. Further deterioration in the job market could lead to more aggressive actions from the Fed, such as a 50-bps interest rate cut in September. This is not the base case, but something worth monitoring. Nonetheless, investors reacted positively to yesterday’s FOMC news with the S&P 500 index climbing 1.6%.
Insights from big tech’s earnings reports
Despite the selloff in several of the market’s biggest tech companies in July, Alphabet, Microsoft, and Meta Platforms have each reported solid earnings and, importantly, provided updates about their massive ongoing investment plans around AI. On a combined basis, these three companies plan to spend approximately $165 billion annually on capital expenditures to support their growth which is primarily aimed at AI infrastructure and related opportunities. Amazon and Apple will shed more light on their investment plans later today. However, based on these comments, any concerns about a bubble in AI hardware spending may be premature.
Microsoft, for instance, told investors that revenue growth from its AI-driven Azure Cloud business was limited by available capacity and that it would continue investing due to increasing demand. Moreover, AI applications have, so far, provided the biggest productivity gains for tasks such as software development, but its Copilot product is beginning to penetrate markets such as sales and administration tasks which will yield tremendous productivity gains for business customers. Alphabet and Meta Platforms shared similar plans to massively expand their present cloud capacity to serve their customers’ growing demands for a wide variety of applications. While skeptics raise concerns that we may be in the midst of an unsustainable investment cycle in AI, these reports suggest we should not expect a bust any time soon.
July’s performance highlights
July saw a divergence in market performance, with bonds and gold outperforming, small caps surging, and tech stocks underperforming. The broad S&P 500 managed very modest gains (+1.1% in July). There was a big divergence between Small Caps (+12% in July) and Nasdaq (-1.5% in July). The Magnificent 7 stocks added an incredible $440 billion in market value yesterday which helped limit their July losses (-2.5% in July). At their worst point, the Magnificent 7 were down 10% from their highs.
Treasury yields plunged in July. The 10-year U.S. Treasury yield slid from 4.5% to 4.1% while the U.S. Treasury 2-year yield fell from 4.8% to 4.3%. Softening economic data, favorable inflation readings, and increasing expectations for fast approaching Fed rate cuts caused the yield declines. The lower 10-year yield will support stock prices so long as the softening economy doesn’t worsen enough to raise fears of a recession.
So far, about half of the S&P 500 companies have reported their quarterly results. Eight of 11 sectors have reported year-over-year growth in earnings, with four reporting double-digit growth. Overall, companies are on pace to deliver an average of 10% earnings growth, which would be the highest since the fourth quarter of 2021. Of course, we know that the average is skewed by the large tech companies, but accelerating growth has also broadened to the financials and healthcare sectors. Materials has lagged due to declining commodities prices.
While we don’t have to swim in the Seine like some of the Olympic athletes, investors must weather August and September which have historically produced murky returns. Let’s look forward to clearer waters ahead when the Fed likely follows through on its September rate cut.
Actor Jason Momoa Turns 45 today, Film Director Sam Medes is 59, and Tempestt Bledsoe from the Cosby Show turns 51 today.
Christopher Gildea 610-260-2235